Why Detroit's Cars Are Outshining Japan's

It's cute. Fun. Green, even. Honda's (NYSE:HMC) new CR-Z is the first hybrid sports car to hit America, with frisky handling, modish looks, and mileage in the mid-30s. In a market cluttered with me-too imitators, it's a genuine original.

But get out your camera if you spot one: They're likely to be scarce on American roads. Even though it's derived from Honda's popular Fit subcompact, the CR-Z is an innovation without much of a market. Since it's a two-seater, the CR-Z will only appeal to singletons or families with at least one other car. It has less power than competing sports cars and gets lower mileage than other hybrids, prompting some critics to wonder, what's the point? "The CR-Z is not a bad car," says website Jalopnik. "But there's something missing here — it lacks a certain Honda joy." For Honda, such faint praise is a damning indictment.

Just a couple of years ago, the Japanese automakers could do no wrong. Honda, Toyota (NYSE:TM), and Nissan (OTCPK:NSANY) had cornered the market on reliability and done a better job figuring out what American consumers wanted than the homegrown automakers from Detroit. Toyota earned green cred by surging to a huge lead in hybrids. Honda became synonymous with practicality, thanks to innovations like the foldaway "Magic Seat" on its minivan. Nissan set itself apart with slick styling and affordable performance cars like the Maxima sedan and 370Z.

It helped, of course, that General Motors, Ford (NYSE:F), and Chrysler spent the last decade self-destructing, delivering thousands of new customers to their Japanese competitors every month. Japan's share of the US market surged from 25 percent in 2000 to 40 percent just eight years later. Detroit's share of its home market plunged from 65 to 47 percent over that time. The recession that struck in 2008 pushed the domestic auto industry into a full-blown collapse.

Now, after two years of repair work, Detroit is finally starting to regain lost ground. J.D. Power & Associates predicts that the Detroit 3 will gain a point of market share this year — a small uptick, but the first improvement since 1995. Toyota's safety recalls have been an unexpected gift, but the Detroit 3 are still beating some long odds. GM has overcome the stigma of its humiliating 2009 bankruptcy and government bailout and stabilized its market share with half the nameplates it had two years ago. Chrysler, which also got bailed out after declaring bankruptcy, is close to profitability, even though its turnaround plan isn't even halfway complete. And after losing $30 billion between 2006 and 2009, Ford has picked up two points of market share and become a moneymaking machine.

The 2009 bailouts clearly saved GM and Chrysler, and helped Ford indirectly. But Detroit's revival seems real because it's fueled by cars that people actually want to buy — not by the huge rebates or low-margin fleet sales of yore. The Japanese, meanwhile, have been struggling with lukewarm products and upstart competitors targeting them aggressively. James Bell of car-shopping site KBB.com, says:

Toyota is down a rung or two on the excitement scale. Honda seems to be rudderless on the product side.

And in KBB's latest "brand watch" study, Korea's Hyundai has bumped Nissan from the top five brands most considered by people shopping for a new car.

The J3, as the Japanese giants are known, remain profitable, proficient companies nowhere near the depths that the Detroit 3 fell to. Yet Detroit, surprisingly, is beating them at their own game. On Consumer Reports' list of the most "buzzworthy" 2011 models, for instance, five are domestics, and four of those are small cars — Detroit's biggest weakness for decades. Korea's Kia earned two spots on the list, while each of the J3 earned just one. Honda's new Odyssey minivan made the list — but the CR-Z, despite its novelty, didn't.

The turnaround in small cars may be the biggest sign of Detroit's rehabilitation. For decades, Detroit hewed to an old saying: "Small cars, small profits. Big cars, big profits." Beginning in the 1970s, the Japanese proved that reliable economy cars build loyalty and credibility among buyers who will stick with the brand as their standard of living rises and they upgrade their wheels. Abominable compacts from Detroit — like the Dodge Neon and Chevy Cavalier — did the opposite, driving customers away. When gas spiked to $4 a gallon in 2008, there was barely an American compact worth buying.

The exodus of buyers was a belated wake-up call, and the Detroit 3 finally began to refine their small car lineups, even as the red ink gushed in 2009. Now comes the payoff. The new Ford Fiesta, for example, ranks first out of 32 models in the U.S. News rankings of affordable small cars. GM's new Chevrolet Cruze ranks sixth. Chrysler's turnaround is moving more slowly, but a lineup of forthcoming models from its new parent firm, Fiat, has generated enthusiasm so far, and the Fiats are popular in Europe.

Detroit has also targeted a particular vulnerability of Toyota and Honda: Their cars are considered boring. In J.D. Powers' latest vehicle-appeal survey, Toyota ranks near the bottom and Honda is merely average. That's partly by design. The two automakers have hit the mass-market jackpot with family vehicles like Honda's Accord, Civic, and CR-V, and Toyota's Camry, Corolla, and RAV4, and topping the sales charts year after year requires inoffensive designs that are squarely mainstream. But many buyers still want excitement and originality, and they tend not to find it in Honda or Toyota showrooms. An era of joyless frugality, like we seem to be in, may even intensify the statement that frustrated consumers want to make with their cars.

That's where the Cadillac CTS sports sedan comes in. Compared to the swept, flowing style of most luxury cars, the CTS looks like it might short-circuit the software in a wind tunnel, with sharp, angular edges that turn heads. To some it's bold, to others, gaudy. But nobody thinks it's boring. The CTS coupe is even more abrupt, with a posture that on first glance seems almost cartoonish. A high-performance "V" model rockets from 0 to 60 in less than four seconds. The look-at-me act has worked. Car and Driver counts the CTS as one of its "10 best," and the car ranks 6th on the U.S. News list of upscale midsize cars, where it's tied with some tough competition: the Audi A4 and the Lexus ES. (The top-ranking car in the category: the Buick Regal.)

Standout designs animate many of the other cars fueling Detroit's recovery. The revitalized Ford Mustang, Chevy Camaro, and Dodge Challenger have brought muscle-car bravado back to automakers that never should have given it up. The Chevy Traverse and its twin, the GMC Acadia, have cut into the minivan market with a Mommobile that's cooler-looking and more fun to drive. All three automakers are taking more chances with European-based models, which don't always translate well to the U.S. market. Next year, for example, Ford will introduce American buyers to the C-Max, which has been popular in Europe for a decade. The tallish, $20,000 microvan can fit 7 and is powered by a thrifty four-cylinder engine.

Detroit is also enjoying a minor resurgence in pickups and larger vehicles, thanks to a slowly improving economy and relatively cheap gas. Sales of Chevy, Ford and Dodge pickups are up by double-digits over last year, with competing trucks from Toyota and Nissan falling behind. That's a lifeline for Chrysler in particular, since more than 70 percent of its sales are light trucks, according to Edmunds.com.

It takes longer for a carmaker to improve its reputation for quality, yet Ford and GM are making strides there, too. For one thing, the Detroit 3 have finally put some actual engineering behind all their jawboning about eco-friendly this and that. The Fiesta and Cruze get highway mileage in the mid 30s, with engines that are spunky enough to let drivers feel comfortable on the highway. Sophisticated transmissions are other new technologies are pushing up the mileage on a range of mid-size cars and crossovers. Ford's new Explorer, coming this winter, will come with either a four- or six-cylinder engine — but no V-8 — allowing it to achieve top mileage near 30 mpg. The best the outgoing Explorer could do was 21 mpg.

Those kinds of improvements are pushing Ford and GM slowly upward in quality rankings. In J.D. Power's latest initial-quality survey, domestic models did better than imports for the first time in the 24 years the firm has been doing the survey. Ford models ranked fifth overall, behind four luxury brands. Buick, Cadillac, Chevrolet, and Chrysler all came in above average. Honda and Nissan performed well too, but Toyota, hamstrung by safety problems and a sudden loss of confidence in its vehicles, fell to the bottom half of the list. In Consumer Reports' reliability testing, Ford has improved significantly, while GM is poised for an uptick thanks to promising new models that have recently replaced aging, substandard flops.

Detroit still faces many hairpin curves, and there's no guarantee that Detroit's notorious arrogance has completely disappeared. Steve Rattner, who ran the auto task force that oversaw the bailouts in 2009, has warned that the insularity and "culture of losing" that sank GM are still a risk. Public offerings for GM and Chrysler will begin to reduce the government's stake in those firms, but it's still not clear when the government will get all its money back, allowing the two automakers to shake the "government motors" epithet for good. Chrysler is the biggest question mark, with its turnaround pinned on new models that for the most part won't arrive until 2011 or later. Ford is in the best shape, but must still revitalize its wan luxury division, Lincoln, and operate with far more debt than its domestic rivals, which wiped the slate clean when they declared bankruptcy.

The Japanese will remain ruthless competitors that test whether Detroit can sustain its momentum. Toyota, in response to its recent problems, is introducing a "smart stop" system on all 2011 models that will make emergency stopping easier and help overcome safety worries. Toyota and Honda both have new products coming meant to prove that they're not boring after all. The big Japanese automakers all have the capability to overtake Detroit on new powertrain technologies, like hybrid-electrics, fuel cells, or natural-gas vehicles. Hyundai (OTC:HYMLF) and Kia (OTC:KIMTF) will increasingly try to gain market share at Detroit's expense, and eventual introductions from China could intensify the pressure to keep prices low. Detroit has come a long way over the last couple of years, but this is no time to turn on the cruise control.